Macroeconomics

Chapter 7:
The Asset Market, Money, and Prices

ECON2220 Intermediate Macroeconomics

Wataru Miyamoto
Spring 2024

Copyright © 2020 Pearson Education Ltd. 1

Overview
• First half: Long-run economic growth

• Second half: Short-run economic fluctuations (business cycles)

• Chapter 7 (Money/Asset market)

2
Overview
• So far, in Chapter 3, 4, and 6, we focused on models with real
variables
• e.g. output, employment, consumption, savings, investment

• All prices were real prices (i.e. measured in the unit of goods like oranges).

• No nominal prices (i.e. measured in the unit of dollars) and no money

• We introduce money in this chapter.

3
Chapter Outline
• What Is Money?
• Portfolio Allocation and the Demand for Assets
• The Demand for Money
• Asset Market Equilibrium
• Money Growth and Inflation

4
What Is Money?
• Money: assets that are widely used and accepted as payment
• Matter of degree
• Currency, check, gold, bank deposit (checking/saving account), credit card,
Octopus Card etc.

• The functions of money

• Medium of exchange
• Unit of account
• Store of value

5
What Is Money?
• The functions of money
• Medium of exchange
• Barter is inefficient—double coincidence of wants (i.e. both parties have to agree
with the trade)
• e.g. You want to sell oranges and want to buy apples. Need to find someone
who wants to sell apples and buy oranges.
• Money allows people to trade their labor for money, then use the money to buy
goods and services in separate transactions
• Money permits people to trade with less cost in time and effort

• For this, money needs to be universally acceptable

• This feature is most fundamental (leads to the second and third features)

6
What Is Money?
• The functions of money
• Unit of account
• Money is basic unit for measuring economic value
• Prices in HKD
• Simplifies comparisons of prices, wages, and incomes
• The unit-of-account function is closely linked with the medium-of-exchange
function

7
What Is Money?
• The functions of money
• Store of value
• Money can be used to hold wealth
• Most people use money only as a store of value for a short period and for small
amounts, because it earns less interest than money in the bank

8
What Is Money?
• Brief history of money
• 1st stage: Money as a commodity
• Gold, silver or other valuable items
• Government issued coins
• Money has intrinsic value

• 2nd stage: Money in paper bills

• “Gold certificates”: people could exchange government issued certificates with
actual gold
• Later fiat money: No intrinsic value, not backed by any commodity

• 3rd stage: Electronic money

• Credit and debit cards
• No dollar bills, coins, gold
9
What Is Money?
• Measuring money—the monetary aggregates
• Distinguishing what is money from what isn’t money is sometimes difficult
• Saving account, checking account, time deposits

• There’s no single best measure of the money stock

10
What Is Money?
• Measuring money
• The M1 monetary aggregate
• Currency held by the public
• Checking accounts
• Saving accounts
• Saving accounts were added to M1 in 2021
• Demand deposits (a bank account with which deposited funds can be withdrawn at
any time)

• All components of M1 are used in making payments, so M1 is the closest

money measure to our theoretical description of money

11
What Is Money?
• Measuring money
• The M2 monetary aggregate
• M2 = M1 + less money like assets

• Additional assets in M2:

• small (< $100,000) time deposits
• Time deposits bear interest and have a fixed term (substantial penalty for early
withdrawal)
• non-institutional MMMF (Money Market Mutual Fund) balances
• MMMFs invest in very short-term securities and allow limited checkwriting

12
Table 7.1: U.S. Monetary Aggregates (December 2021)
• Amounts in billions of dollars

13
What Is Money?
• Monetary system in Hong Kong
• Hong Kong Monetary Authority (HKMA)
• De facto central bank
• Ensure the stability of HKD and the banking system
• Linked exchange rate system
• Established in 1983
• 1 USD at 7.8 HKD
• HKMA authorizes note-issuing banks (three commercial banks below) to issue
new banknotes but they need to deposit an equivalent value of USD with HKMA
• HSBC
• Standard Chartered Bank
• Bank of China

14
What Is Money?
• Next, we consider money market equilibrium
• Money supply
• Money demand
• Money supply = money demand

• The money supply

• Money supply = money stock = amount of money available in the economy
• A central bank (or the government) decides money supply (In the US, the
Federal Reserve System, sometimes called “the Fed”)

15
What Is Money?
• The money supply
• How does the central bank of a country increase the money supply?
• Use newly printed money to buy financial assets from the public—an open-
market purchase

• To reduce the money supply, sell financial assets to the public to remove money
from circulation—an open-market sale

• Open-market purchases and sales are called open-market operations

16
What Is Money?
• The money supply
• How does the central bank of a country increase the money supply?
• Could also buy newly issued government bonds directly from the government
(i.e., the Treasury)

• This is the same as the government financing its expenditures directly by printing
money

• This happens frequently in some countries (though is forbidden by law in the

United States)

• Throughout text, use the variable M to represent money supply; this might be
M1 or M2

17
Portfolio Allocation and the Demand for Assets
• Next, let’s consider money demand
• How do people allocate their wealth among various assets? The
portfolio allocation decision

• You have 1m HKD worth wealth and want to allocated it across different
assets
• Money vs other assets(Bonds/Stocks/Houses etc.)

• We can derive money demand function

18
Portfolio Allocation and the Demand for Assets
• How is the demand for money determined?

• Determinants of the demand for assets

• Expected return
• Risk
• Liquidity
• (Time to maturity)

19
Portfolio Allocation and the Demand for Assets
• Expected return
• Rate of return = an asset’s increase in value per unit of time
• Bank account: Rate of return = interest rate
• Corporate stock: Rate of return = dividend yield
+ percent increase in stock price

• Investors want assets with the highest expected return (other things equal)

• Returns not known in advance, so people estimate their expected return

20
Portfolio Allocation and the Demand for Assets
• Risk
• Risk is the degree of uncertainty in an asset’s return

• People don’t like risk, so they prefer assets with low risk (other things equal)

• Risk premium: the amount by which the expected return on a risky asset
exceeds the return on an otherwise comparable safe asset
• e.g. government bonds vs corporate bonds

21
Portfolio Allocation and the Demand for Assets
• Liquidity
• Liquidity: the ease and quickness with which an asset can be traded
• Money is very liquid
• Assets like automobiles and houses are very illiquid— long time and large
transaction costs to trade them
• Stocks and bonds are fairly liquid
• Investors prefer liquid assets (other things equal)

22
Portfolio Allocation and the Demand for Assets
• Time to maturity
• Time to maturity: the amount of time until a financial security matures and
the investor is repaid the principal
• For simply, you can assume the maturity of a bond is one year in a model.
• e.g., 1-year government bond

23
Portfolio Allocation and the Demand for Assets
• Types of assets and their characteristics
• People hold many different assets, including money, bonds, stocks, houses,
and consumer durable goods
• Money has a low return, but low risk and high liquidity

• Bonds have a higher return than money, but have more risk and less liquidity

• Stocks pay dividends and can have capital gains and losses, and are much more
risky than money

• Ownership of a small business is very risky and not liquid at all, but may pay a
very high return

• Housing provides housing services and the potential for capital gains, but is quite
illiquid
24
Portfolio Allocation and the Demand for Assets
• Types of assets and their characteristics
• Households must consider what mix of assets they wish to own

• Table 7.2 shows the mix in 2006, 2009, and 2021

• The table illustrates the large declines in the value of stocks and housing in
the financial crisis

25
Table 7.2: Household Assets, 2006, 2009, and 2021

26
Portfolio Allocation and the Demand for Assets
• Asset Demands
• Trade-off among expected return, risk, liquidity, and time to maturity
• Assets with low risk and high liquidity, like checking accounts, have low
expected returns
• Investors consider diversification: spreading out investments in different
assets to reduce risk
• The amount a wealth holder wants of an asset is his or her demand for that
asset

• The sum of asset demands equals total wealth

• You are allocating your wealth across different assets

27
The Demand for Money
• The demand for money is the quantity of monetary assets people
want to hold in their portfolios
• As an asset, money demand depends on expected return, risk, and liquidity

• Money is the most liquid asset

• Money pays a low return (0 nominal return on currency)

• People’s money-holding decisions depend on how much they value liquidity

against the low return on money

28
The Demand for Money
• Key macroeconomic variables that affect money demand
• Interest rates
• As an asset

• Price level
• Real income
• For transactions (liquidity)

29
The Demand for Money
• Price level
• The higher the price level, the more money you need for transactions

• Prices are 10 times as high today as 65 years ago, so it takes 10 times as much
money for equivalent transactions

• Nominal money demand is thus proportional to the price level

• e.g. Price of one orange 65 years ago = $1
• Price of one orange today = $10
• You need 10 times more money to do the same transaction

30
The Demand for Money
• Real income
• The more transactions you conduct, the more money you need

• Real income is a prime determinant of the number of transactions you

conduct

• So money demand rises as real income rises

• Real income is essentially real GDP

31
The Demand for Money
• Real income
• But money demand isn’t proportional to real income, since higher-income
individuals use money more efficiently, and since a country’s financial
sophistication grows as its income rises (use of credit and more sophisticated
assets)
• Robinson’s income = 1m HKD
• Friday’s income = 2m HKD
• Suppose Robinson holds 0.1m HKD as money(currency + checking and saving
accounts). Friday holds less than 0.2m HKD as money.

• Result: Money demand rises less than 1 for 1 with a rise in real income

32
The Demand for Money
• Interest rates
• An increase in the interest rate or return on nonmonetary assets decreases
the demand for money
• Nonmonetary assets: Aggregate of bonds, stocks, etc.

• An increase in the interest rate on money increases money demand

• E.g. saving account interest rate

• Though there are many nonmonetary assets with many different interest
rates, because they often move together we assume that for nonmonetary
assets there’s just one nominal interest rate, 𝑖

33
The Demand for Money
• The money demand function

𝑀𝑑 = 𝑃 × 𝐿 𝑌, 𝑖

• 𝑀𝑑 is nominal money demand (aggregate)

• 𝑃 is the price level
• 𝐿 is the (real) money demand function
• 𝑌 is real income or output (GDP)
• 𝑖 is the nominal interest rate on nonmonetary assets

34
The Demand for Money
• The money demand function
• As discussed above, nominal money demand is proportional to the price level

• A rise in 𝑌 increases money demand; a rise in 𝑖 reduces money demand

• We exclude 𝑖 𝑚 from the money demand function since it doesn’t vary much
• 𝑖 𝑚 : return on money (e.g. saving account interest rate). We ignore it as it is
typically small

35
The Demand for Money
• The money demand function
• Alternative expression:

𝑀𝑑 = 𝑃 × 𝐿 𝑌, 𝑟 + 𝜋 𝑒

• A rise in r or 𝜋 𝑒 reduces money demand

• Alternative expression 2:

𝑀𝑑
= 𝐿 𝑌, 𝑟 + 𝜋 𝑒
𝑃

𝑀𝑑
• In terms of real money demand =
𝑃

36
The Demand for Money
• The money demand function
• Q: Why is the nominal interest rate entering money demand function
instead of the real interest rate?

𝑀𝑑 = 𝑃 × 𝐿 𝑌, 𝑖
• Think about the return on money and nonmonetary assets
• Example
• 2% annual nominal interest rate for bonds
• 1HKD to 1.02HKD after a year
• What is the nominal return on money?
• Q: Suppose the expected inflation rate is 3%. What is the real interest rate for
bonds and money?

37
The Demand for Money
• Zero lower bound of nominal interest rate
• The nominal interest rate cannot go below 0%
• Why?
• Suppose the nominal interest rate is negative 1% (e.g. Saving account interest
rate is -1%). What are you going to do?

• Q: Can the real interest rate become negative?

38
Figure: Nominal and real interest rates in the United
States, 1960–2017

39
The Demand for Money
• Other factors affecting money demand
• Wealth: A rise in wealth may increase money demand, but not by much

• Risk
• Increased riskiness in the economy may increase money demand (risk in stock
market)
• Times of erratic inflation bring increased risk to money, so money demand
declines

40
The Demand for Money
• Other factors affecting money demand
• Liquidity of alternative assets: Deregulation, competition, and innovation
have given other assets more liquidity, reducing the demand for money
• Now quite easy to trade stocks
• Payment technologies: Credit cards, ATMs, and other financial innovations
reduce money demand
• In general,
𝑀𝑑 = 𝑃 × 𝐿 𝑌, 𝑖, 𝑤𝑒𝑎𝑙𝑡ℎ, 𝑟𝑖𝑠𝑘, 𝑒𝑡𝑐.

• We consider 𝑌 and 𝑖 as the most important factors for money demand so we

focus on these two

41
The Demand for Money
• Money demand in general

𝑀𝑑 = 𝑃 × 𝐿 𝑌, 𝑖, 𝑊𝑒𝑎𝑙𝑡ℎ, 𝑟𝑖𝑠𝑘, 𝑒𝑡𝑐.

• Questions
• Because of the spread of Coronavirus, the stock market is experiencing large
fluctuations. What happens to the money demand?
• High risk for nonmonetary assets, people demand more money

• During the Christmas season, people go shopping more frequently. What happens to
the money demand?
• People want to have more liquidity for transactions, so people demand more money

• GDP decreases by 10% this year, what happens to the money demand?
• People do less transactions and thus demand less money
42
Summary 9: Macroeconomic Determinants of the
Demand for Money
Causes money demand
An increase in to Reason
Price level, P Rise proportionally A doubling of the price level doubles the
number of dollars needed for transactions.

Real income, Y Rise less than Higher real income implies more transactions
proportionally and thus a greater demand for liquidity.

Real interest rate, r Fall Higher real interest rate means a higher return
on alternative assets and thus a switch away
from money.
Expected inflation, πe Fall Higher expected inflation means a lower real
return on money and thus a switch away from
money.
Nominal interest rate on Fall Higher return on nonmonetary assets makes
nonmonetary assets, i people less willing to hold money

43
Summary 9: Macroeconomic Determinants of the
Demand for Money
Causes money
An increase in demand to Reason
Nominal interest rate on Rise Higher return on money makes people more
money, im willing to hold money.
Wealth Rise Part of an increase in wealth may be held in
the form of money.
Risk Rise, if risk of Higher risk of alternative asset makes money
alternative asset more attractive.
increases
Blank Fall, if risk of money Higher risk of money makes it less attractive.
increases
Liquidity of alternative Fall Higher liquidity of alternative assets makes
assets these assets more attractive.
Efficiency of payments Fall People can operate with less money.
technologies

44
The Demand for Money
• Elasticities of money demand

𝑀𝑑 = 𝑃 × 𝐿 𝑌, 𝑖

• How strong are the various effects on money demand?

• Statistical studies on the money demand function show results in elasticities
• Elasticity: The percent change in money demand caused by a one percent
change in some factor (𝑃, 𝑌, 𝑖)
• Why percent change? Unit free. If you measure money demand in HKD/USD,
percent changes are the same.
• 1m HKD, 1% increase of 1m HKD= 0.01m HKD
• 1m HKD = 12900 USD, 1% increase of 12900 USD = 129 USD=0.01m HKD

45
The Demand for Money
• Elasticities of money demand
• Income elasticity of money demand
• % change in money demand when there is 1% increase in income
• Positive: Higher income increases money demand
• Less than one: Higher income increases money demand less than
proportionately
• Empirical results: income elasticity = 2/3
• Income increases by 1%, money demand increases by 1x2/3=0.666%

46
The Demand for Money
• Elasticities of money demand
• Interest elasticity of money demand
• % change in money demand when the nominal interest rate increases by 1
percentage point
• Small and negative: Higher interest rate on nonmonetary assets reduces money
demand slightly
• E.g. -1/5: 1 percentage point increase in the nominal interest rate decreases money
demand by 1/5%

• Price elasticity of money demand is unitary, so money demand is proportional

to the price level
• If the price level increases by 10%, money demand increases by 10%

47
The Demand for Money
• Money demand
𝑀𝑑 = 𝑃 × 𝐿 𝑌, 𝑖
• Example
2
𝑀𝑑 𝑌3
= 1
𝑃
1+𝑖 5
• Compare before (time 𝑡) and after (time 𝑡 + 1)
2 2
𝑀𝑡𝑑 𝑌𝑡 3 𝑑
𝑀𝑡+1 𝑌𝑡+1 3
• = 1 𝑎𝑛𝑑 = 1
𝑃𝑡 𝑃𝑡+1
1+𝑖𝑡 5 1+𝑖𝑡+1 5
• Take the ratio and natural log (remember how to compute growth rates using
natural log. A growth rate is a percent change.)

48
The Demand for Money
2
𝑑 𝑌𝑡+1 3
𝑀𝑡+1 1
𝑃𝑡+1 1 + 𝑖𝑡+1 5
l𝑛 = 𝑙𝑛 2
𝑀𝑡𝑑
𝑌𝑡 3
𝑃𝑡 1
1 + 𝑖𝑡 5

∆𝑀𝑑 ∆𝑃 2 ∆𝑌 1 1 + 𝑖𝑡+1
𝑑
− = − 𝑙𝑛
𝑀 𝑃 3 𝑌 5 1 + 𝑖𝑡
• In the end,
∆𝑀𝑑 ∆𝑃 2 ∆𝑌 1
𝑑
= + − ∆𝑖
𝑀 𝑃 3 𝑌 5
1+𝑖𝑡+1
• where 𝑙𝑛 = 𝑙𝑛 1 + 𝑖𝑡+1 − 𝑙𝑛 1 + 𝑖𝑡 ≅ 𝑖𝑡+1 − 𝑖𝑡
1+𝑖𝑡
• (Remember 𝑙𝑛 1 + 𝑖𝑡 ≅ 𝑖𝑡 when 𝑖𝑡 is close to 0.)
49
The Demand for Money
∆𝑀𝑑 ∆𝑃 2 ∆𝑌 1
𝑑
= + − ∆𝑖
𝑀 𝑃 3 𝑌 5
• Questions
• What is the price elasticity of money demand? 1.
• What is the income elasticity of money demand? 2/3.
• What is the interest rate elasticity of money demand? -1/5.
1 ∆𝑖
• Notice it is NOT − . As 𝑖 is already in %, we prefer ∆𝑖. For example, 5% to
5 𝑖
∆𝑖 0.01
6% means ∆𝑖 = 0.01. However, = = 0.2 and it is not intuitive.
𝑖 0.05
• Sometimes 1/5 above is called semi-elasticity

50
The Demand for Money
• Long-run relationship between money and inflation
• Long-run: Longer than a decade
• Alternative theory of money: Quantity theory of money
• Velocity of money
• What’s velocity?
• Velocity (𝑉) measures how much money “turns over” each period (i.e. how
many times money is used)

𝑉 = 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃Τ𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑚𝑜𝑛𝑒𝑦 𝑠𝑡𝑜𝑐𝑘 = 𝑃𝑌Τ𝑀

• e.g. 100 HKD money, nominal GDP=1000. What’s velocity? 10

• Data: Plot of velocities for M1 and M2 (Fig. 7.2) shows fairly stable velocity for
M2, erratic velocity for M1 beginning in early 1980s

51
Figure 7.2: Velocity of M1 and M2, 1959Q1–2021Q4

52
The Demand for Money
• In the long run, the velocity of M2 is stable
• How about the short run?
• Let’s look at quarterly growth rates
𝑀𝑉 = 𝑃𝑌
• So, in growth rates
∆𝑀 ∆𝑉 ∆𝑃 ∆𝑌
+ = +
𝑀 𝑉 𝑃 𝑌
∆𝑀
• : growth rate of money
𝑀
∆𝑃 ∆𝑌
• + : growth rate of nominal GDP
𝑃 𝑌
∆𝑉
• Compute growth rates of velocity in the short run
𝑉

53
Figure: Growth rates of velocity for M2, 1960Q1–
2019Q4

54
The Demand for Money
• Data of velocity
• M2 velocity is closer to being a constant in the long run, but not over short
periods

• Assume constant velocity 𝑉, where velocity isn’t affected by income

or interest rates. Then,
𝑀𝑡 1
= 𝑌𝑡
𝑃𝑡 𝑉

• Quantity theory of money: Real money demand is proportional to real

income
𝑀𝑡𝑑
= 𝑘𝑌𝑡
𝑃𝑡

55
The Demand for Money
• Quantity theory of money
𝑀𝑡𝑑
= 𝑘𝑌𝑡
𝑃𝑡

• Special case of money demand 𝑀𝑑 = 𝑃 × 𝐿 𝑌, 𝑖 where 𝐿 𝑌, 𝑖 = 𝑘𝑌

• Assume money supply = money demand. Then,

𝑀𝑡
= 𝑘𝑌𝑡
𝑃𝑡

56
The Demand for Money
• A restatement of the quantity theory
∆𝑀 ∆𝑃 ∆𝑌
= +
𝑀 𝑃 𝑌
∆𝑌 ∆𝑀
• In addition, assume is mostly unaffected by . This is called the
𝑌 𝑀
neutrality of money (More on this later).
∆𝑌 ∆𝑀 ∆𝑃
• Or assume is small compared with or and relatively constant
𝑌 𝑀 𝑃

• Then, inflation is mostly determined by changes in 𝑀

• “Inflation is always and everywhere a monetary phenomenon.” – Milton
Friedman
• This may be true in the long run.

57
Figure : The relationship between money growth and
inflation (1990-2011)

58
The Demand for Money
• Recap
• This long run relationship may not hold in the short run
∆𝑉
• =0 (Quantity theory of money) may not hold in the short run.
𝑉
∆𝑌 ∆𝑀
• may be affected by in the short run. Neutrality of money does not
𝑌 𝑀
hold.

• Example (long-run)
• In 10 years,
∆𝑀 ∆𝑉 ∆𝑌
• = 0.5, = 0, = 0.1
𝑀 𝑉 𝑌
∆𝑃 ∆𝑀 ∆𝑌
• Then, = − = 0.5 − 0.1 = 0.4
𝑃 𝑀 𝑌
∆𝑀
• If the central bank sets =1
𝑀
∆𝑃 ∆𝑀 ∆𝑌
• Then, = − = 1 − 0.1 = 0.9
𝑃 𝑀 𝑌
59
The Demand for Money
• In the long run, inflation is determined by money supply

• Question
• Suppose GDP is determined by the Solow model and 𝑉 is constant and money
supply determines inflation.
• Why is it difficult to stabilize inflation, at least in the long run?
• Why would a central bank print too much money if it knows that high inflation
will result?
• We still observe hyperinflation.
• Data (IMF): Link

60
Figure : Hyperinflations in History

61
The Demand for Money
• One reason
• Seigniorage revenue
• Government has an incentive to print more money to pay its bills (this revenue is
called seigniorage)
• If the government cannot finance spending with taxes or borrowing,
printing money may be only alternative
• Especially during and after wars
• Collecting tax may be difficult in developing countries .

• Tom Sargent: “Persistent high inflation is always and everywhere a

fiscal phenomenon”
• Need a sound fiscal policy to avoid persistent high inflation

62
The Demand for Money
• One idea to solve this problem: Fixed exchange rate to commodities
(e.g. gold) or other currencies
• Restrict the government’s ability to print money freely
• These do not always work in history
• Prices of commodities are not always stable
• Risk of devaluation (or default), people need to believe the government to
pay gold/other currencies
• Hong Kong: Fixed exchange rate to USD

63
The Demand for Money
• Gold standard system
• A currency is pegged to the price of a specific amount of gold
• The US was on a pure gold standard system between 1873 and 1933
• Halted convertibility domestically and devalued the USD about 41% in 1933.
• Convertibility for international transactions ended in 1971.
• The UK was on a gold standard system until 1931.

• Was the price level stable?

64
Figure : US and UK Price Level, 1865-1914

65
The Demand for Money
• Persistent deflation
• Why?
• Production of gold did not keep up with increased demand for gold
• Under the gold standard, inflation is dictated by world production of gold (supply
of gold = M), relative growth in world economy (=Y that determines demand for
gold as money) and other demand for gold

• Not clear why we want supply of gold to dictate inflation

66
Figure : Gold Production

67
Figure : Price of Goods

68
Figure : Currency System (Exchange Rate Regimes) in
the World

69
Asset Market Equilibrium
• Next let’s think about equilibrium as usual
• Asset market equilibrium—an aggregation assumption
• Assume that all assets can be grouped into two categories, money and
nonmonetary assets
• Money includes currency (and checking accounts)
• Pays interest rate 𝑖 𝑚
• Supply is fixed at 𝑀
• Nonmonetary assets include stocks, bonds, land, etc.
• Pays interest rate 𝑖 = 𝑟 + 𝜋 𝑒
• Supply is fixed at NM

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Asset Market Equilibrium
• Asset market equilibrium occurs when quantity of money supplied
equals quantity of money demanded
• 𝑚𝑑 + 𝑛𝑚𝑑 = total nominal wealth of an individual

• 𝑀𝑑 + 𝑁𝑀𝑑 = aggregate nominal wealth (7.6)

(from adding up individual wealth)

• 𝑀 + 𝑁𝑀 = aggregate nominal wealth (7.7)

(supply of assets)

• Subtracting Eq. (7.7) from Eq. (7.6) gives

𝑀𝑑 − 𝑀 + 𝑁𝑀𝑑 − 𝑁𝑀 = 0

71
Asset Market Equilibrium
• So excess demand for money 𝑀𝑑 − 𝑀 plus excess demand for
nonmonetary assets 𝑁𝑀𝑑 − 𝑁𝑀 equals 0

• So, if money supply equals money demand, nonmonetary asset

supply must equal nonmonetary asset demand; then entire asset
market is in equilibrium
• We can focus on the market for money

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Asset Market Equilibrium
• The asset market equilibrium condition

𝑀 = 𝑀𝑑 = 𝑃 × 𝐿 𝑌, 𝑟 + 𝜋 𝑒

• 𝑀 is determined by the central bank

• 𝜋 𝑒 is fixed (for now)
• Remember 𝑖 = 𝑟 + 𝜋 𝑒

• The labor market determines the level of employment

• Given employment, a production function determines 𝑌
• Given 𝑌, the goods market equilibrium condition determines 𝑟

73
Asset Market Equilibrium
• The asset market equilibrium condition
• With all the other variables in the asset market equilibrium condition
determined, the asset market equilibrium condition determines the price
level

𝑀
𝑃=
𝐿 𝑌, 𝑟 + 𝜋 𝑒

• The price level is the ratio of nominal money supply to real money demand

74
Summary
• Money
• Means of transaction
• Unit of account, store of value
• M1, M2
• Money supply
• Exogenous
• Will discuss how policy makers decide later
• Money demand function
• Portfolio allocation problem
• Money vs nonmonetary assets
• Price level, interest rate and income

75
Summary
• Velocity of money
• M2
• Long run relatively stable, short run unstable
• Quantity theory of money
• Long-run determination of price level
• Neutrality of money
• Inflation
• Long-run
• Monetary phenomenon
• Financing expenditure
• Short-run
• Will study in Ch.9

76
Review
• Assume the money demand function discussed before
∆𝑀𝑑 ∆𝑃 2 ∆𝑌 1
𝑑
= + − ∆𝑖
𝑀 𝑃 3 𝑌 5

• Suppose the central bank wants to achieve 2% inflation rate

• Assume the changes in output and the nominal interest rate are given
as follows and are not affected by money supply
∆𝑌
• = 0.03, ∆𝑖=0.05
𝑌

• What should be the growth rate of money supply?

77
Review
• 2% inflation rate
∆𝑃
• = 0.02
𝑃
• In equilibrium, money supply = money demand
∆𝑀 ∆𝑀𝑑 ∆𝑃 2 ∆𝑌 1 2 1
• = = + − ∆𝑖 = 0.02 + 0.03 − 0.05
𝑀 𝑀𝑑 𝑃 3 𝑌 5 3 5
• In the end, we get
∆𝑀
• = 0.03
𝑀

78